Product innovation by supplying domestic and foreign markets

This paper uses European firm-level survey data to provide some robust empirical evidence that suppliers engaged in production to order (PTO) for foreign firms are more likely to introduce product innovations than those engaged in PTO for domestic firms, even when differences in size, R&D and productivity are controlled for. We propose a demand-driven theoretical explanation based on the interactions between an upstream producer of a specialized input and a downstream producer in a framework of incomplete contracts, agency frictions, and imperfect information. Some of the model's implications, namely that higher internationalization costs entail a lower innovation premium for suppliers engaged in PTO for foreign customers and that the foreign PTO innovation premium is higher in sectors producing differentiated goods, are supported by the data.